Net Gains: Why You Shouldn't Take a 401(k) Loan

Feb. 27, 2008 — -- Thirteen years ago, my wife and I borrowed $3,500 from our 401(k) plans to help cover a down payment for our home.

It was one of the dumbest financial moves we ever made. By one calculation, it may have cost us about $18,000 in future retirement savings.

We would have been better off adding the $3,500 to the mortgage balance rather than tap retirement savings. At most, that would have cost us an extra $7,300 in interest payments. In reality, it probably would have been less given the mortgage-interest tax deduction and later refinancing opportunities.

Like many 401(k) borrowers, I rationalized my decision. I told myself we would be paying interest to ourselves. What I didn't realize at the time was we stripped away the tax advantages of a 401(k) account and the power of compounding.

The result? We had to come up with an extra 25 cents for every dollar we borrowed just to pay down the principal, never mind the interest. Even more painful was the lost compounding potential of our original $3,500 investment.

I bring this up now not because I dwell over financial regrets. Other moves I made turned out to be better decisions that more than made up for the dumb ones.

Still, I offer my own 401(k) borrowing experience as a warning to those who think a loan from their retirement savings plan is a smart financial move when cash is tight.

I know these are tough economic times for many families, so I won't lecture those facing true hardship. But I urge them and anyone else thinking about taking out a 401(k) loan to do so only as an absolute last resort.

Consider every other alternative first. In some cases, borrowing against home equity may be a better long-term move. That, of course, assumes you have available home equity to tap in a falling real estate market.

A sizable withdrawal from retirement savings -- even if you pay the money back -- can mean a substantial setback to financial security in your later years when you may have even fewer options. And if you are unable to repay the loan, your retirement will take an even harder hit.

Amid the subprime loan crisis, a housing-market collapse and talk of recession, there are signs these are perilous times for retirement savings. The Associated Press last week reported big 401(k) providers like Fidelity Investments are seeing increases in loan requests and hardship withdrawals as workers look for a financial lifeline.

I'm worried the situation will only get worse.

For the unfamiliar, let's review the rules surrounding 401(k) withdrawals and loans.

Generally, money deducted from your paycheck on a pretax basis and deposited into a 401(k) account is not to be touched until at least age 59½ at the earliest. Tax law allows for hardship withdrawals, but the standards used by the IRS make it tough to qualify.

In most cases, an outright early withdrawal from a 401(k) will result in a 10 percent penalty plus ordinary income tax on the amount withdrawn. That means on a $10,000 withdrawal you could lose $4,000 in taxes and penalties if you are in the 25 percent tax bracket and live in a state with a 5 percent income tax.

The easiest way around the 10 percent penalty plus the ordinary income tax is to obtain a loan from your 401(k) account through your employer. Typically, employers allow 401(k) loans as a means of encouraging employees to participate in the plan. The thinking is that allowing workers limited access to retirement savings will encourage greater participation and higher contribution levels.

The problem is even the less-onerous loan provision still exacts a financial toll.

There are at least three ways a worker loses out when taking a 401(k) loan:

Lost investment earnings: When you remove money from a 401(k) account, you take away its potential to earn tax-deferred investment returns and grow through the power of compounding. Yes, you are paying interest on the loan, but the interest rate on the loan is often lower than the return you can earn on a well-diversified portfolio of stock and bond mutual funds.

In my case, the lost compounding potential came at a particularly high cost because at the time of the loan my wife and I were more than 35 years from retirement. That's the major source of the lost $18,000 in retirement savings I mentioned above.

After-tax payments: Borrowing from a 401(k) strips away its tax advantages. Each dollar you remove had been contributed on a pretax basis, meaning you did not pay an income tax on that dollar when you first received it from your employer.

But when it comes to paying back the 401(k) loan, you are using dollars already taxed by the government. To pay back one dollar borrowed, you many need to earn $1.18 or more, depending on your tax bracket and what state you live in.

Lower contributions: Those carrying the burden of 401(k) loan repayments are likely to make lower contributions to retirement savings than they otherwise would. Even if they do not lower what they had been contributing, increased contributions are less likely.

The greatest danger may be inability to repay the loan. If you lose your job or change jobs voluntarily, the employer may require immediate repayment on the outstanding loan balance. If you default on the loan, you will be hit with the 10 percent penalty and ordinary income tax mentioned above.

For these reasons and the sake of your future retirement, consider a 401(k) loan only as an absolute last resort, not as a quick fix to short-term cash crunch. Don't make the same mistake I did.

This work is the opinion of the columnist and in no way reflects the opinion of ABC News.

David McPherson is founder and principal of Four Ponds Financial Planning (www.fourpondsfinancial.com) in Falmouth, Mass. He previously worked as a financial writer and editor for The Providence Journal in Rhode Island. He is a member of the Garrett Planning Network, whose members provide financial advice to clients on an hourly, as-needed basis. Contact McPherson at david@fourpondsfinancial.com